Creative Accounting

Creative Accounting BY skhan9189 International Journal of Trade, Economics and Finance, Vol. 2, No. 6, December 2011 Use or Abuse of Creative Accounting Techniques Syed Zulfiqar Ali Shah, Safdar Butt, and Yasir Bin Tariq India who are always short of this product. It takes three years for a cement plant to start production. By the time the new plants came into production in late nineties, the countrys economic scenario had changed. The government had no money for development, the economy was generally in recession, and construction had virtually come to a halt.

With tremendous overcapacity, the cement prices started alling precariously. The companies got together and slashed production. Plants started operating at an average of around 22% production capacity to ensure that prices do not fall. The prices drop stopped but still it did not help much. Now cement is one industry where the largest slice of costs is fixed and time related, rather than operations related. As much as 72% of annual costs of a new cement plant may comprise of only two items namely depreciation and interest. Both of these are fixed and computed on the basis of time.

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As a result, a low capacity utilization meant higher cost per ton of cement produced n any period, leading to huge losses. One creative way found around this situation was to convert the depreciation cost from a fixed time related cost to a variable charge. To achieve this end, the method of computing annual depreciation by dividing the total plant cost over the number of plant’s useful life was abandoned. Instead, the total cost of plant was divided over the total cement production to be expected from the plant over its entire life – thereby computing depreciation cost per ton of cement produced.

This drastically curtailed the periodic charge to the Income Statement and improved the rofitability fgures. This had no implication for corporation taxes as depreciation is not a tax allowable expense virtually anywhere in the world. So using a creative accounting tool, the companies were able to show profits, or minimize losses, during a difficult period when the capacity utilization was low. This enabled them to keep the investors reasonably comforted and the staff relaxed.

The interesting thing is that when the demand rose and companies started operating at higher capacity, they did not need to change their accounting policy. Hence, without any deception, ill-will or dishonesty, the directors of Now lets have a view on some technical aspects of this phenomenon. Abstract??”The study has been conducted to have a detailed view on creative accounting. A very important question has been tried to be answered in this study that why managers do creative accounting and how they become successful in performing such practice in the presence of stringent rules and procedures.

Another aspect of creative accounting has been tried to be explored that whether this creative accounting practice is good for the companies or it brings companies in crises situation. Discussion based model has been used on the basis of past references and xperiences. Link of governance with creative accounting practices has also been tried to be explored in the study. At the end it is concluded that the complex and diverse nature of the business transactions and the latitude available in the accounting standards and policies make it difficult to handle the issue of creative accounting.

It is not that creative accounting solutions are always wrong. It is the intent and the magnitude of the disclosure which determines its true nature and Justification. Index Terms??”creative accounting, earnings management, corporate governance. l. INTRODUCTION Subject of Creative Accounting is normally portrayed maligned and negative act. As soon as these words “Creative Accounting” are mentioned, the image that emerges in one’s mind is that of manipulation, dishonesty and deception. Study wishes to propose today that creative accounting is a tool which is much like a weapon.

If used correctly, it can be of great benefit to the user; but if it is mishandled or goes into the hands of the wrong person, it can cause much harm. Creative Accounting has helped more companies to get out of a crisis than land them into a crisis. The weapon is almost lways innocent; the fault whenever it emerges lies with the user. Coming from a developing country where stock exchanges listings often fail to reflect the true credentials of a company, There are many cases where companies have benefited tremendously by using creative accounting techniques and remained afloat during difficult times.

Before we go into Jargon and intricacies of the subject, let me relate an episode from Pakistan’s cement industry. In mid-nineties, the country suffered an acute shortage of cement. The government announced a number of incentives plants were planned – seven to be precise. The combined roduction of these and existing plants was expected to meet the demands of cement for the country as well as leave a surplus for export to its neighbors like Afghanistan and II.

SOME DEFINITIONS OF CREATIVE ACCOUNTING Creative Accounting refers to the use of accounting knowledge to influence the reported figures, while remaining within the Jurisdiction of accounting rules and laws, so that instead of showing the actual performance or position of the company, they reflect what the management wants to tell the stakeholders. “Purposeful intervention in the external financial reporting process with the intent of obtaining some Manuscript received October 9, 2011; revised December 30, 2011. S. Z. Ali Shah is with International Islamic University, Islamabad, Pakistan (email: Zulfiqar. [email protected] com). S.

Butt and Y. B. Tariq are with Mohammad Ali Jinnah University. Islamabad (email: [email protected] com; [email protected] com). 531 exclusive gain”. “Creative accounting is the transformation of financial accounting fgures from what they actually are to what preparer desires by taking advantage of the existing rules and/or ignoring some or all of them”. [1] “Every company in the country is fiddling its profits. Every set of published accounts is based on books which have been gently cooked or completely roasted. The fgures which are fed twice a year to the investing public have all been changed in order to protect the guilty.

It is the biggest con trick since the Trojan horse… In fact this deception is all in perfectly good taste. It is totally legitimate. It is creative accounting. ” [2] Many terms can be used to describe the practices of changing the facts in accounting, e. g. cooking the books, aggressive accounting, massaging the numbers, window dressing, earnings management, etc. Ill. MOTIVATION FOR CREATIVE ACCOUNTING 3] summarize the major motivations to manage earnings compensation, and financial liabilities. [4] provides a conceptual framework for analyzing earnings management from an informational perspective. 5] added insider trading in this list of motives. Managers aware of misstatement of profits can benefit by trading the securities. [6] suggest three broad objectives for earnings management: minimization of political costs; minimization of the cost of capital and maximization of managers’ wealth. [7] refers to earnings management in buyout cases. [8] find that firms manage earnings prior to seasoned equity offers and IPO’s. 9] conclude that firms manage earnings to meet financial analysts’ forecasts. The managers are motivated for fixing financial statements for either managing position or profits.

Following are important concerns for managers Common Labels for Financial Numbers Game Label Definition Aggressive Accounting A forceful and intentional choice and application of accounting principles done in an effort to achieve desired results, typically higher current earnings, whether the practices followed are in accordance with GAAP or not Earnings management The active manipulation of earnings toward predetermined target, which may be set by anagement, a forecast made by analysts, or amount that is consistent with a smoother, more sustainable earnings stream Income Smoothing A form of earnings management designed to remove peaks and valleys from a normal earnings series, including steps to reduce and “store” profits during good years for use during slower years Intentional misstatements or omissions of reporting amounts or disclosures in financial statements, done to deceive financial statement users, that are determined to be fraudulent by an administrative, civil, or criminal proceeding Creative accounting Any and all steps used to play the financial ractices numbers game, including the aggressive choice and application of accounting principles, fraudulent financial reporting, and any steps taken toward earnings management or income smoothing Source: The Financial Number Game by Charles W. Mulford & Eugene E. Comiskey, 2002 Oohn Wiley & Sons) Source: http://davepear. com/blog/2009/06/ A. To Meet Internal Targets The managers want to cook the books for meeting internal targets set by higher management with respect to sales, profitability and share prices. B. Meet External Expectations Company has to face many expectations from its stakeholders. The Employees and customers want long term survival of the company for their interests. Suppliers want assurance about the payment and long term relationships with the company.

Company also wants to meat analyst’s forecasts and dividend payout pattern. C. Provide Income Smoothing Companies want to show steady income stream to impress the investors and to keep the share prices stable. Advocates of this approach favor it on account of measure against the ‘short-termism’ of evaluating an investment on the basis of the immediate yields. It also avoids raising expectations too high to be met by the management. The window dressing can be done before corporate events like IPO, acquisition or before taking a loan. [10] reports the tendency of companies nearing violation of debt covenants is twice or thrice to make income increasing accounting policy changes than other companies); E.

Taxation The creative accounting may also be a result of desire for some tax benefit especially when taxable income is measured through accounting numbers. F. Change in Management There is another important tendency of new managers to show losses due to poor management of old management by some provisions. [1 1] found this tendency in US bank anagers. Unfortunately, all the above definitions imply a misuse of creative accounting techniques for the purpose of deception or attaining dishonest ends. While this may be applicable to many of the situations, I believe that it is not true of all the companies. ‘V. IMPORTANCE Creativity in accounting can be bad, that doesn’t mean that it must be bad.

If creative accounting coheres with ethical and legal standards as well as the generally accepted 532 than one method of valuation of inventory or method of depreciation. Secondly, there is discretion available to management on any particular method. ccounting principles (GAAP), they can yield immense benefits to the company and its stakeholders. Creative accounting may help maintain or increase the share price by decreasing debt level to lower risk and by showing improved profits. The high share price can help the company in raising new capital and in takeover attempts. Some authors believe that if management delays the release of financial information to the market, with an intention of taking some advantage from the delay, that also falls within the meaning of creative accounting.

Once again, if the intentions are not to harm any stakeholders’ nterest, this can hardly be described as dishonest. According to [1 2], [1 3] earning management techniques reduce the variability of earnings and, therefore, improved predictability of future earnings help in enhancing price/earning multiples. However, they claim that abnormal accruals over time tend to reverse and are readily detected by investors. This clearly calls for moderation in using even healthy techniques for managing earnings. A. Misuse of Accounting Policies As stated above, the accounting standards and policies cannot cover every aspect of business transactions. Therefore considerable latitude is available to companies to play within the legal ring.

The commonly cited example of misuse of accounting policies includes exploiting the loopholes in revenue recognition standards. There is a wide debate on this issue among accounting policy makers, standard setters and practicing companies as when to recognize and record the revenue in the book of accounts. So, it is a common practice to book revenue even before recognizing it to increase the profits. Sometimes companies do no wants to show a profit above a certain level, in that case companies defer revenue to educe their profits. Timing of expense recognition is used in the similar manner to achieve the desired objectives i. e. either to show increased profits or decreases profits.

Rewards of the managing Profits (Earnings Management) & Financial Position Category The Objectives & Benefits Companies Trying To Achieve Share-Price Effect Higher Share Price Reduce Share Price Volatility Increase Firm Value Lower Cost of Equity Capital Increased Value of Stock Options Borrowing Effects Cost Management Performance Evaluation Effects Lower Borrowing Costs Relaxed or Less Stringent Covenants B. Changes in Accounting Policy Due to the latitude available in accounting policies, companies can alter their profit fgures by changing the accounting policy and deliberately omit to mention the change of policy in notes or omit to give correct impact of the change. For example Changing the closing stock valuation method and do not inform the readers of the financial statements that what impact either positive or negative it could have on earnings. Change the rate of depreciation method or change the method itself to increase or decrease the depreciation expense. Financial Increased Bonuses based on Profits/ Share Price Political Cost Effects

Decreased Regulations Avoidance of Higher Taxes Eugene E. Comiskey, 2002 Oohn Wiley & Sons vil. HOW TO DELIBERATELY PRESENT A FALSE PICTURE A company wishes to show higher profits, it has number of options to achieve this objective. ??? It can overvalue its closing stock thus by decreasing the cost of goods sold; it will show increased profit and on the other hand increased total assets in the balance sheet. ??? By ignoring the provisions for bad debts [legal obligations, the current profits can be overstated. ??? It can book false gains through sales purchase back. For example if company owns a piece of land which were ought, let us say, 30-40 years ago at a cost of Rs. 150,000.

Now the company is bound to show the cost of this piece of land on historical basis as required by accounting standards. If the current market price of that piece of land is say approx. 30 million, the management purchase it back. By executing this under the table transaction, the company balance sheet footing will be increased by Rs 30 million. Now that the company would have legally bought the property at Rs 30 million, it will be Justified to show it in the balance sheet at that amount (being the cost). ??? Playing with debits and credits If we talk purely in accounting language, the entire accounting process is about the correct use of “debits” V.

EXPERIENCE FROM THE WORLD Unreasonable and dishonestly excessive use of Creative Accounting led to the downfall down of numerous highprofile companies in the United States during the great depression. This gave rise to the need for developing GAAP. Recently, the Great Giants like Enron failed as a result of cooking the books to hide the economic substance. One example is US film industry which claims huge expenses against successful movies to lower the remuneration of writers, producers, and actors [14]. 15] reports on how a change in accounting method boosted K-Mart’s quarterly profit fgure by some $160 million, by a happy coincidence distracting attention from the company slipping back from being the largest retailer in the USA to the number two slot. VI.

FUNCTIONING OF CREATIVE ACCOUNTING Accounting standards do not cover all aspects and many methods are present for one treatment. e. g, there are more 533 and “credits”. In the very first course of accounting, students are taught how the five main items of assets, liabilities, equity, revenue and expenses are treated in the books of accounts. The below given table explains or the readers that if an item increases or decreases how this will be treated in the accounting Journal. Account Type Assets an expenditure under say $5000 as an asset, even if its benefits is likely to be spread over several years. Varying this limit to say $2,000 can easily increase profits while hiking up this limit may lead to lower profits.

Firms virtually have a free hand in timing the booking of their revenues at any stage starting from the moment sales contracts are signed till the promised product or service has been fully delivered to and accepted by the clients. For this we can refer to a classic example of Microsoft hich was heavily fined by US SEC for its manipulative revenue recognition policy. Microsoft recognized only a small percentage (20-30%) as revenue at the time of the sale and remaining amount was kept as provision for future after sales services. Why Microsoft adopted that strategy. The answer is to (1) hide substantial profits, (2) signaling effects, (3) avoiding complacency and last but not the least (4) to report smoothed earnings to its shareholders & stakeholders. TABLE l: DEBITS & CREDITS RULE Increase is Recorded Decrease is Recorded Debit Credit Expense Revenue Liability Equity

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